U.S. municipal investors have historically sought risk distinctions among bonds within a narrow band of default risk and loss severity, because compared to the corporate bond default experience, post-War municipal bond defaults have been extremely rare and recoveries in the event of default have been quite high (Even during the Depression, municipal credit losses were, on average, lower than those experienced in the corporate sector, as indicated in George Hempel’s study of Depression-era municipal defaults, The Post-War Quality of State and Local Debt, (NBER, 1971). Between 1929 and 1937, when 4,770 state and local governments defaulted on $2.85 billion, or 15.4% of the average municipal debt then outstanding, recovery was high and relatively rapid).

Local governments facing impending financial crises have often received state-level support that has averted defaults. In the event of default, municipalities have rarely declared bankruptcy, and their debt service payments have generally been resumed quickly, often with little loss of principal, or even interest, to investors.

Yet there seemed to be little interest in trying to distinguish ratings for government agencies from corporate debt. In July 2008, the Connecticut Attorney General office sued the ratings agencies over what they found as a consistent undervaluing of public debt. Here’s the fact sheet with links to complaints against specific agencies.

It’s worth taking a minute to read from examples of the complaint. The general argument is that muni debt doesn’t behave like corporate debt, and when you control for the rating US public debt is significantly much safer than corporate debt – to the point where it looks like the ratings agencies are far more aggressive with US public debt than they’ve ever been with emerging markets, Enron/Worldcom/tech stocks or the wave of CDO financial innovation. What are some reasons why this might be the case?

A couple of examples from the complaints:

In June of 2001, S&P published a study commissioned by its Analytics Policy Board that reviewed public bond defaults rates from 1986-2000. The June 2001 report concluded that “the number of defaults and cumulative default rates are extremely low for public finance obligations rated by Standar & Poor’s” and that “no defaults of ‘AAA’ or ‘AA’ rated debt occurred in the 1986-2000 period.” S&P attributed this stability to the fundamental nature of governments in that “governments have ‘perpetual’ existence” and that bankruptcy typically is not an option for governments….

In July of 2001, S&P published a public bond default study which found that public bonds default at much lower rates than corporate bonds of similar or higher credit ratings. S&P published at least six subsequent default studies on public bonds from April 2004 through May of 2008. Each of these S&P studies reached the same conclusion as S&P’s July 2001 study. Moody’s was aware of all of the S&P studies….

In June of 2002, Moody’s published the “highlight” results from its own default study that Moody’s began in 2000. Moody’s found that for “the period covering 1970-2000, the one year, issuer-weighted average default rate for all Moody’s rated municipal issuers – regardless of their rating level – is just .01% versus 1.30% for all corporate issuers. In other words, for the study period, Moody’s found that public bonds were on average 130 times less liekly to default than corporate bonds during the first year after issuance…

In November of 2002, Moody’s published the final version of its public bond default study. The Moody’s study concluded that “the 1, 5 and 10-year cumulative default rates for all Moody’s rated municipal bond issuers have been .0043%, .0233%, and .0420%, respectively compared to .0000%, .1237%, and .6750% for Aaa-rated corporate bonds during the same time period.” In other words, Moody’s concluded that public bonds as a group, even when including public bonds with low credit ratings, have lower default rates on average than the highest, “Aaa” rated corporate bonds….

In October of 2005, an internal report prepared for S&P’s Analytics Policy Board unequivocally confirmed that “U.,S. public sector entities have historically exhibited substantially lower default rates than corporates, for a given rating.” Despite this conclusion, S&P still did not consider rating public bonds according to their true credit risk and continued to represent that its ratings were comparable across asset classes….

In March of 2007, Moody’s published a report purporting to outline how much public bonds had been underrated by Moody’s as compared to corporate bonds. The Moody’s report provided a “map” detailing the gaping differences between public and corporate bond credit ratings. The Moody’s map showed that in many cases the default rates of public bonds were equal to or less than corproate bonds rated as many as seven notches higher by Moody’s….

As one Moody’s exectuive conceded in an August 31, 2006 email: “I think there is clearly a mismatch between the default data and people’s perception of the risk associated with municipal credits.”

The Ratings Agencies is one area where the implementation of reform post Dodd-Frank is up for grabs. Here’s an interview I did with Jerome Fons about what went wrong with the ratings agencies over the past decades that I thought was pretty informative on the topic.

This is all why, in general, we want to watch the market price of US government debt as well as the market price of inflation, both of which don’t seem to care about the ratings agency’s warning:

When there was a push in Congress to authorize receivership authority for Fannie and Freddie, the firm issued a statement saying that it would downgrade the GSEs if that happened. Likewise, when Georgia passed its anti-predatory lending legislation, S&P announced that it would no longer rate securities containing mortgages originated in that state. In both cases they cited “regulatory uncertainty,” but that somehow didn’t influence their rating of structured finance products after a judge called into question the bankruptcy remoteness of SPVs. (This is difficult to explain, but you can find a discussion on pp. 33-34 of Mason and Rosner’s article on the agencies: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1027475.)

I don’t know what the endgame is here (and there probably isn’t one), but I can’t help but wonder.